ABSTRACT
Financial instruments replace gold as banks' reserves While banks clearly want to protect themselves against demands for redemption, they also have an incentive to reduce the cost of the reserves they hold to meet such demands. These costs will fall anyway as the banking system develops, because public demands for redemption will fall as confidence in the banking system increases, and the lower demands for redemption imply that the banks can operate on lower reserve ratios.6 The banks will reduce the cost of holding reserves further by offering financial instruments as alternative redemption media. The costs of storing and protecting financial instruments are considerably lower than for gold, and many financial instruments have the benefit that they bear explicit returns. The banks would usually have little difficulty in persuading the public to accept financial instruments rather than gold when they demand redemption. The public would normally prefer them because of their lower storage, protection and moving costs. To qualify as a suitable redemption medium, an asset must have a value substantially independent of the bank that is using the asset to redeem its issues (i.e. it must not use its own debt). Obvious examples are the debt or equity of other firms. Note that there is nothing to stop an individual bank using the debt of another bank to redeem its own liabilities - indeed, banks will often find it particularly convenient to redeem their liabilities by giving out other banks' notes or by drawing cheques on other banks - but the banking system as a whole cannot redeem all its
liabilities by drawing cheques on itself - there must be some 'outside' redemption medium at the aggregate level. Of course, if the banks give out financial assets instead of gold there is a danger that the original issuers may default, the assets may fall in value, and so on, but they could always refuse a particular instrument and the banks would have to provide them with something else instead. If the public accept a particular redemption medium, on the other hand, that implies that they consider it at least 'as good as gold' and that they are willing to accept any risk it entails.
